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Industries:  General 

Six Steps to Transform Capex Procurement

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By: Suchismita Dhal
Customer Success Lead

calender17 May 2018

With inputs from Sakthi Prasad, Content Manager

Six Steps to Transform Capex Procurement

U.S. companies are increasing spending on their businesses at the fastest pace in years. As a result, spending on factories, equipment and other capital goods by the S&P  500 companies is expected to have reached $166 billion in the first quarter, up 24 percent from a year earlier, the Wall Street Journal reported, citing Credit Suisse data going back to 1995.

Capital expenditure (Capex) has always been on top of every CFO’s agenda. Globally, the attitude toward capital spending is also taking a leap. The investment decisions regarding Capex are critical not only because of the size of spending but also because of the strategic goals of an organization. It has been observed that most of the times, policies or the assumptions for Capex budgeting and Capex approval are not very clear in an organization.

According to Fernando Mero, Head of Procurement of NetShoes Inc., a Brazilian e-commerce firm: “A fixed asset expense is included as an asset on the balance sheet, increasing the value of the assets of the organization, while not directly affecting the profit and loss statement. In contrast, if a company decides to rent out an asset instead of buying it, the expenses attributed to this lease will be tied to the OPEX -- in other words, operational expenses that result from the ‘day-to-day’ activities.”
 

Procurement is one of the crucial parts of Capex, but is it able to contribute reasonably in the present establishment of Capex policies in various organizations?

As an age-old convention, organizations have been following very similar practices when it comes to procurement under Capex. The project manager responsible for project execution would initiate the process as a request for Capex. Usually, he is the one who understands the requirements best. The project manager must define technical requirements for project, scope of work, project timelines, schedules, contract requirements, etc. Only after this will the request be sanctioned/ approved by the authorized managers to get a final nod for fund allocation. In most of the organizations, it has been observed that the procurement team gets involved considerably late and only contributes at a tactical level.

This traditional approach is not only time consuming, it also deprives the organization from gaining numerous opportunities to optimize the Capex as well as its management. As procurement gets involved only at a later stage of the process, it becomes increasingly difficult to bring value to the organization through contract evaluations and negotiations. The major focus of the procurement team remains to be the minimization of the cycle time through quick tactical solutions.
 

Relationship between Project Manager and Procurement Team

Relationship between Project Manager and Procurement Team

Source: Beroe Analysis
 

The struggle to manage financial accounting for OPEX and Capex might seem to be the hardest job for organizations, but there are many other challenges in managing Capex.

The major challenge in the traditional approach for Capex approval and procurement is its long, slow, and inefficient processes, with lapses in planning, multiple approvals, and repetitive and recurring processes at different sanctioning levels. Organizations are still struggling to manage financial accounting for OPEX and Capex separately. Other constraints include unclear definition of approval limits, absence of a comprehensive purchasing policy, and guidelines on maintaining retention money, bank guarantees, etc., and the way project risks/compliances should be captured, etc. This also lacks transparency amongst the stakeholders. Isolation of the initiator or associated stakeholders, such as planning and procurement at an early stage of budget preparation, could give a better return in any capital investment. In addition to long approval processes, manual Capex approvals also increase challenges due to manual errors and underutilization or escalation of budget costs due to lack of transparency.
 

Return-on-investment is not the only deciding factor for any capital spend; there are many other approving considerations for Capex.

During planning for capital investments, various factors are considered, such as nature of project, investment amount, return from investment, short- and long-term strategy of the organization, and other financial and operational considerations. Each capital spend is usually evaluated differently in order to consider whether it is for an expansion, regular replacement, or maintenance, or to increase efficiency. Different parameters are set based on this criteria.
 

Key Considerations for Capex

Key Considerations for Capex

Source: Beroe Analysis

The following are few key considerations that are needed during project evaluation:

  • Key assumptions used in the justification of the project.
  • Safety implications related to occupational health issues.
  • Details of expenditure that replaces existing assets.
  • Basic financial analysis (e.g., discounted cash flow analysis, payback, ROI, etc.)
  • Financial justification for specific project types, such as modernization/technology upgradation, energy conservation or cost reduction, capacity expansion or debottlenecking, etc.
  • The financial payback to the company related to the purchase of the particular capital item/project (applicable to the cost reduction/income producing justification category only).
  • The amount of sunk costs.
     

Generally, all these activities are undertaken during budget planning in order to roll out a workable Capex budget and avoid unbudgeted capital expenditures. In general, projects worth more than $50,000 need a formal documentation with project code and other details, along with a cost benefit analysis from the requester. However, it is prudent to keep records for even small-scale projects to have a better clarity in accounting. Following is a sample of standard authorization or sanction matrix for capital investment approval:
 

Sample Sanction/Authorization Matrix

LevelofResponsibility

Approval Limit (USD)

$10K - 50K

<=$ 500K

<=$ 1 Million

<=$ 2 Million

<=$ 5 Million

<=$ 20 Million

>$ 20 Million

Board of Directors

           

MD/ CEO

         

Executive/Senior Vice President

       

Financial Controls Director/CFO

Functional Director/Head

 

Project Manager/Requester

*The approval limit varies from organization to organization based on strategic decisions, managerial controls, financial policies, etc.

Source: Beroe Analysis

The project manager is the point of contact for the organization with respect to any questions, issues, reporting (project status, financial status, etc.) that the organization may have during the course of the capital project. Throughout the project, the ownership remains with the business head and not the requester or the project manager. In case of new installations, replacement, or technology upgrades, disposals of fixed assets must be made in accordance with the organization procedure. This should include concerns such as disposal of old assets, rate of depreciation, transfer of fixed assets, etc.

Organizations have understood that they need to adopt new approaches and make necessary amendments in existing policies in order to ensure the best results in the future.

Most of the leading organizations across various industries are establishing an extensive capital budgeting process that helps in allocating funds directly to the ownership level. Companies are starting to develop and implement effective policies and procedures that not only help in evaluating the financial returns, quantifying values, and risk considerations, etc. but would also help in bringing transparency in roles and responsibilities. In the new approach, business unit leaders, and not the project manager, are responsible for post-capital outcomes.
 

Centralized Capex Approval and Execution Model

Centralized Capex Approval and Execution Model

Source: Primary Expert 2, Beroe Analysis

Procurement managers are involved at very early stages, such as budgeting and planning, unlike the earlier days when procurement managers were only involved in tactical activities. A cross-functional Capex management committee is created from the very beginning for capital planning and budgeting processes to develop a firm understanding of resource requirements and establish links with each project delivery team member from an early stage. Companies are focusing more on training staff on areas such as TCO, reporting requirements, forecasting process, and procurement policy and procedures.

For implementing a centralized Capex management process, companies can develop their own models to fit their requirements. However, the success and sustainability of the policy would highly depend on how well the new policy is knitted into the system. Following are few action points that would be useful in developing any new policy or methodology for Capex management:
 

Action points for optimizing Capex procurement

Action points for optimizing Capex procurement

Source: Beroe Analysis

Action 1: Documentation of Guideline and Standard Procedure

To optimize the process, different business units need to work with the procurement team to develop a common process and procedure for Capex. Variation and inconsistency in the processes can increase the cost of procurement for the company. Steps such as change order process, order acceptance process, invoice approval process, supplier evaluation process, and cost of sales increase the cost of procurement, mostly due to lack of standard guidelines.
 

Action 2: Cross-functional Team for Appraisal and Evaluation

Best-in-class Procurement Organizations create a cross-functional Capex committee for appraisal and evaluation of Capex. Preparing a Capex budget in isolation of procurement, planning, or engineering teams would never deliver the best solution. The involvement of a cross-functional team as Capex steering committee would bring various dimensions and numerous opportunities for cost savings. This committee is responsible for project evaluation, analysis, and planning, giving the management the right set of information so that it can take an apropos decision.
 

Action 3: Appropriate Project Evaluation Methodology

The NPV method is one of the most common methods for project evaluation. It is also simple to use. It eliminates few disparities observed while using the IRR method, such as non-uniqueness of projects and irregular cash flow. In practice, other valuation methods such as accounting hurdle rate, rate of return, payback period, and economic value augmentation are used in conjunction with NPV. Payback is normally used to measure some other effects, such as the effect of the project on liquidation.

Project evaluation Methodologies

Source: Beroe Analysis

Apart from financial analysis, project evaluations should evaluate the risk component attached to the project. Many organizations use discount rate that has been adjusted with the risk characteristic of a particular project or business entity. Real option analysis combined with risk scores is also suggested to maintain managerial flexibility. It does not ignore the idea of the management’s ability to intervene in an ongoing project.
 

Action 4: Process Automation (E-Platforms):

E-Platforms are available, which could improve the Capex approval process through structured Capex requests and approvals integrated with supporting documents and budgets. The project manager initiates all the requests. The originator of the request gets a notification email at each step. If tasks are not completed in specified days, reminder emails are sent out. Managers can approve, reject, or ask for additional information about the authorization request at each stage of the approval. Every stakeholder is thus informed about the progress of the request.

An automated Capex request software solution would be beneficial in achieving the following:

  • Significantly increase the speed of the approval process without any manual routing
  • Improve productivity by eliminating system procrastinations and other routing errors
  • Promote transparency in Capex request status (pending approval, completion, or rejection)
  • Systematic documentation of all processed Capex requests for later reuse
  • Ensuring that Capex requests meet board approval through electronic intimation
  • Ensure process compliance and audit compliances of project
     

Action 5: Focus on Effective Analysis on Total Cost of Ownership (TCO) / Life Cycle Costing (LCC):

Total Cost of Ownership (TCO) or Life Cycle Cost analysis is a practice for analyzing all the costs together to streamline the internal aspects of the procurement process and to establish a sustainable procurement policy for the future. To formulate such a procurement policy, we need to focus on two major parameters: cost reduction and supply chain risk reduction. Ultimately, these two levers can help achieve the primary goal of generating more revenue in the organization and improvising internal processes.
 

Action 6: Regular Review for Better Control & Monitoring:

To achieve best results from the action points above, there has to be a structured control and monitoring system in place. A periodic review of Capex project progress would give a better grip over the resource allocation and utilization for project execution.
 

Conclusion:

For organizations to realize the actual benefits out of this initiative, they must toil hard to restructure their age-old practices regarding Capex approval. Automated workflow for Capex approval would not only complete the approval process faster, it would also ensure uninterrupted availability of critical infrastructure. Periodic audit trails would provide a tighter control at all stages, prevent complicity, and bring more transparency in Capex procurement. Various ERP software such as SAP, Oracle, and Microsoft do provide solutions for process automation. Apart from these, many licensed business process management (BPM) solution providers such as Skelta, I- Nexus, K2.net Solutions, Integrity, and Finario can develop customized solutions.

To merit the sweets of success, the procurement team must take the lead role in the organization to bring about this transformation. Early procurement team intervention for Capex budgeting and planning could bring around 18–20 percent of cost savings from Capex procurement. With change management programs, companies can bring best practices into the system. This change is required across all business units of a business entity to realize the specific competitive advantage of Capex procurement.
 

Experts Profile:

  • PE1: Director, leading global FMCG manufacturing company, 25 years of experience
  • PE2: Project manager, engineering & technical, heavy industry, MNC, 15 years of experience

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